Module 3 Case

1. a. A large hurricane severely damages a major U.S. city.

A large hurricane represents a diversifiable risk because this calamity is something that does not happen in every major city in the United States. This risk can be reduced or somewhat eliminated if the investment would be relocated to a city that is not normally hit by a hurricane. If the investor would consider the size of the United States, which will provide a relatively big number of suitable cities for the investment, there is a big chance that he will find a city that is suitable and almost hurricane free.

b. A substantial unexpected drop in the price of oil.

This oil price drop is an example of an un-diversifiable risk. It is like the oil price hike which is something that cannot be corrected by diversification. It represents a risk that the investors must accept because this deflation rate affects a number of companies and not only one. Even though the drop in the price of oil is somewhat an advantage to many, it will trigger a chain of events that would affect not only the oil industry but also most of the others as well. One major problem would be unemployment, mainly because if the price of the product is dropping then job vacancies will begin to rise to compensate for the decline of income.

c. The CEO of a major corporation is found guilty and sentenced to six months in prison.

Although the CEO of a corporation is one of its most important individual, this event can be considered as a diversifiable risk. This can be considered as such because it only affects one company. Although it is a major corporation, it does not follow that this kind of risk will affect other companies and industries as well.

2. The Capital Asset Pricing Model or CAPM relates risk to the expected return and can be represented by the following equation (McClure)

a. Find . Given that is 7%; rf is 4%; and ?i is 1.5.

b. Find rf. Given that is 15%; is 12%; and ?j is 1.3.

c. What do you think the Beta (b) of your portfolio would be

i. if you own half of all the stocks?

ii. if you own one share of every single publicly traded company?

3. The main ‘message’ of the Capital Asset Pricing Model to:

a. Corporations

The risk in an investment can never be eliminated even by the best possible diversification techniques. Diversification can only minimize risks but not completely eliminate them. To make up for taking on a risk, a rate of return is essential. The Capital Asset Pricing Model or CAPM was developed for us to have a convenient way of calculating the investment risk and the expected return of investment. One application of this model would be in corporate capital budgeting (Jagannathan and Meier).

The main message of the CAPM to corporations is that expected rate of return, just like for the individual investors, would rely mainly on the risks involved. The corporation as a whole will be affected by the risks accepted by the individual investors involved.

b. Investors

Normally, the starting point for CAPM is the risk-free rate. A term called the equity market premium is added to this to compensate for additional risks accredited. This premium consists of the difference of the risk-free rate from the expected market value which is multiplied by a factor beta. Beta is an appropriate measure of the stock’s volatility. It demonstrates how stock prices fluctuate in comparison to the entire stock market. Studies show that an investment with more risks would have a premium with a higher value than the risk-free rate (McClure). Based on this, investors would find out that if the terms of the CAPM is given or known, it would be possible to determine if the investment is a good or a bad one.

An advantage of the CAPM is its simplicity, it just states an investor should earn in one stock and not in another because the other one is riskier. Although CAPM’s validity has been questioned by some researches, it is still one of the most commonly used models by investors. The fact that CAPM is just a theory means that it is somewhat far from reality. Despite the negative claims of others, some studies have proven that CAPM can provide a good starting point for an investor because it is still intended in the right direction.

In general, the CAPM helps the investor to approximate the return of investment that they will regain while considering the risk involved. It would also point out that a more risky asset should call for a higher rate of return compared to less risky ones.

Reference:

Jagannathan, Ravi, and Iwan Meier. “Do We Need Capm for Capital Budgeting?” Financial Management, 2007.

McClure, Ben. “The Capital Asset Pricing Model: An Overview.” 2006.